Certified Residential Appraiser Practice Exam

What does leverage in finance typically refer to?

1. The use of cash reserves for investments

2. The effect of borrowed funds on investment returns

3. The restriction of capital gains tax

4. The depreciation of assets over time

The correct answer is: The effect of borrowed funds on investment returns

Leverage in finance primarily refers to the use of borrowed funds to amplify the potential returns on an investment. When an investor uses leverage, they are essentially increasing their investment exposure without requiring additional capital from their own resources. By borrowing funds, an investor can control a larger asset than they could with their own equity alone. For example, if an investor buys a property using a mortgage, they are leveraging their capital because they are using borrowed money to acquire a more valuable asset. If the investment performs well, leveraging can significantly enhance returns as the profits are calculated on the total value of the investment rather than just the investor’s cash outlay. On the other hand, using cash reserves for investments, restricting capital gains tax, or accounting for depreciation cannot be classified as leverage, as they do not involve borrowing money to increase potential returns. Understanding leverage is important as it can significantly affect both the risk and reward profile of an investment strategy.